Derivatives Regulation Debate Hinged on Arcane Legal Point

The fight between Brooksley Born and other government regulators pivoted on an arcane issue.

Over-the-counter derivatives are private contracts negotiated between two investors who are betting on whether interest rates, stocks, bonds or other items will go up or down in price. There had always been an open question about whether they were futures, which technically in most cases must be traded on an exchange, rather than over the counter.

Treasury Department lawyers argued that if the Commodity Futures Trading Commission began regulating over-the-counter derivatives, they would effectively be defining them as futures and that investors would then refuse to honor existing contracts by saying they were illegal. This would lead to a tsunami of lawsuits, they argued.

This made no sense to Born. Her proposal specifically exempted existing contracts, in her mind invalidating the argument that investors would refuse to honor contracts and be subject to lawsuits. Treasury lawyers also argued that the CFTC had no authority to regulate over-the-counter derivatives.

Born was flabbergasted at this analysis, which she considered bogus. Treasury Secretary Robert Rubin had insisted that all his points were included in a legal analysis by his top attorney, Ed Knight, and Born was eager to see it. But CFTC lawyers could never get Knight on the phone, said Michael Greenberger, a top CFTC official at the time. (One of the Rubin aides they called was Gary Gensler, now President Obama's nominee to head the CFTC. When they told him they couldn't reach Knight, Gensler replied, "Welcome to the club," according to Greenberger.)

Born came to suspect that Rubin was bluffing and there was no analysis.

Knight, now executive vice president and general counsel of the Nasdaq Stock Market, said he does not recall being asked for a legal analysis.

He said, however, that several financial institutions sent their general counsels to meet with Born and "they told her to her face that there was substantial risk."

In the years since, Rubin has sought to portray himself as a believer in regulation of derivatives markets who opposed Born's efforts because he thought it would be politically impossible to persuade the Republican-controlled Congress to go along. Rubin declined to comment for this article, but provided excerpts from his book, "In an Uncertain World," in which he writes that his deputy, Larry Summers, "thought I was overly concerned with the risks of derivatives. . . . Larry characterized my concern about derivatives as a preference for playing tennis with wooden racquets -- as opposed to the more powerful graphite and titanium ones used today."

Eleven years later, the arcane point is still arcane. The Obama administration is considering regulating over-the-counter derivatives, but questions remain about whether this can be done without sparking lawsuits. One possibility being considered, a high-ranking administration official said, is giving new powers to the regulatory agencies, and splitting the job between the Security Exchange Commission and the CFTC. At the CFTC, they're already talking about watching over the markets "Brooksley-style."